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4. Transport becomes expensive (cost of transaction) – This is another crucial
factor for the profitability of the arbitrage trade. Imagine if the cost of transportation
increases from Rs.20 to Rs.30? Clearly the arbitrage opportunity starts looking less
attractive as the cost of execution goes higher and higher. Cost of transaction is a critical
factor that makes or breaks an arbitrage opportunity
5. Competition kicks in (who can drop lower?) – Given that the world is inherently
competitive you are likely to attract some competition who would also like to make that
risk free Rs.30. Now imagine this –
a. So far you are the only one doing this trade i.e buy fish at Rs.100 and sell at
Rs.150
b. Your friend notices you are making a risk free profit, and he now wants to copy
you. You can’t really prevent his as this is a free market.
c. Both of you buy at Rs.100, transport it at Rs.20, and attempt to sell it in the
neighboring town
d. A potential buyer walks in, sees there is a new seller, selling the same quality of
fish. Who between the two of you is likely to sell the fish to the buyer?
e. Clearly given the fish is of the same quality the buyer will buy it from the one
selling the fish at a cheaper rate. Assume you want to acquire the client, and
therefore drop the price to Rs.145/-
f. Next day your friend also drops the price, and offers to sell fish at Rs.140 per KG,
and therefore igniting a price war. In the whole process the price keeps dropping
and the arbitrage opportunity just evaporates.
g. How low can the price drop? Obviously it can drop to Rs.120 (cost of buying fish
plus transport). Beyond 120, it does not makes sense to run the business
h. Eventually in a perfectly competitive world, competition kicks in and arbitrage
opportunity just ceases to exist. In this case, the cost of fish in neighboring town
would drop to Rs.120 or a price point in that vicinity.
I hope the above discussion gave you a quick overview on arbitrage. In fact we can
define any arbitrage opportunity in terms of a simple mathematical expression, for
example with respect to the fish example, here is the mathematical equation –
[Cost of selling fish in town B - Cost of buying fish in town A] = 20
If there is an imbalance in the above equation, then we essentially have an arbitrage
opportunity. In all types of markets - fish market, agri market, currency market, and
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